Fiat Money: Definition, How It Works, Pros & Cons

There is always the possibility of hyperinflation when a country prints its own currency. However, most developed countries have experienced only moderate bouts of inflation. In fact, having some consistent, low level of inflation is seen as a positive driver of economic growth and investment, as it encourages people to put their money to work rather than have it sit idle and lose purchasing power over time.

  1. Federal Reserve has the dual mandate to keep unemployment and inflation low, and using fiat money can help it meet those goals.
  2. Modern economies favor fiat money due to its widespread acceptance, ease of use, and government regulation, facilitating stability and trade.
  3. The country eventually turned to the U.S. dollar as its base currency.
  4. They derive their value largely through the public’s trust in the issuers.

This is much different from a currency backed by gold, for example; it has intrinsic value because of the demand for gold in jewelry and decoration as well as in the manufacturing of electronic devices, computers, and aerospace vehicles. Fiat money has been the dominant form of currency since the United States, and then the rest of the world, dropped the gold standard in the 1970s. That is, the cash has the value that a government attaches to it and does not represent a store of equal value, such as gold. President Richard Nixon decided to abandon the gold standard in 1971.

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The major appeal of representative money was that it was not influenced by inflation. Governments were only able to print money up to the value of the gold they held in their vaults. If the government tries to compensate by printing too much money, the value of its currency drops further.

Examples of Fiat Money

The term “fiat” is a Latin word that is often translated as “it shall be” or “let it be done.” Thus fiat currencies only have value because the government maintains that value; there is no utility to fiat money in itself. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies. In this case, a government decrees the value of the currency, even though it isn’t representative of another asset or financial instrument such as gold or a check. This is not determined by the worth of the material that is used to produce it, and it is not backed by a commodity of equal value.

Why Is fiat money valuable?

As a result, all other national currencies came to be valued against the U.S. dollar. Representative money, on the other hand, is valued based on the instrument backing it, whether that’s a commodity, asset, or another financial instrument such as a check. But there are still other forms of representative money, such as checks, money orders, and bank drafts, that can be exchanged for the value listed on the instrument. Time will tell how cryptocurrencies will ultimately be used for financial transactions, and where they’ll eventually fit in the international monetary system. For now, keep an eye on the developments and consider the pros and cons of fiat money when making decisions about saving and investing. Countries like the UK and the US went on to embrace the gold standard, a monetary system tying a standard unit of currency to the value of a certain amount of gold.

If a government becomes unstable and inflation becomes a problem, the population may lose faith in the money it prints. The government may respond by printing best stocks to buy and watch now too much paper money, which leads to hyperinflation. The U.S. severed its ties with the gold standard in 1971, turning its currency into fiat money.

Examples of fiat currency include the U.S. dollar, Indian rupee, Euro, Japanese yen, and many other national currencies issued and regulated by their respective governments. These currencies are widely used in everyday transactions and are not backed by physical assets like gold or silver but rather derive their value from the trust and confidence in the issuing authorities and their stability. Fiat money is currency that’s backed by the public’s faith in the government or central bank that issued them and is the standard throughout most of the world. It has no intrinsic value, unlike commodity currency, which is linked to the prices of a commodity such as gold or silver. Instead, fiat money derives its value from the trust people place in the governments that issue it.

The African nation of Zimbabwe provided an example of the worst-case scenario in the early 2000s. In response to serious economic problems, the country’s central bank began to print money at a staggering pace, resulting in hyperinflation. Because it’s a currency that is backed by an issuing government, fiat money usually provides some economic stability—but not always. A country that followed the gold standard set a fixed price for gold, buying and selling it at that price. That fixed price was used to determine the value of the currency. So if Britain set the price of gold at £500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.

What Is Fiat Money?

Earlier in U.S. history, the country’s currency was backed by gold (and in some cases, silver). The federal government stopped allowing citizens to exchange currency for government gold with the passage of the Emergency Banking Act of 1933. The gold standard, which backed U.S. currency with federal gold, ended completely in 1971 when the U.S. also stopped issuing gold to foreign governments in exchange for U.S. currency. While fiat money doesn’t have intrinsic value, its value is set by the government that issues the currency. Fiat money can be used to buy goods and services because both parties involved in a transaction agree on the currency’s value. Fiat money is physical money—paper or coins—while representative money is a check or other form of currency that can be exchanged for physical money in a stated amount.

History of fiat currency

When the Great Depression and two world wars severely affected the global economy, world leaders created an international monetary system positioning the US dollar as a global currency. Inflation happens when the value of money diminishes over time, causing a significant hype in the prices of goods and services. Since fiat money has no inherent value, inflation might occur or even become worthless in the event of hyperinflation. A notable example is Hungary’s post-WWII hyperinflation, along with Zimbabwe, which experienced a 99.9% loss of its currency’s value. Virtually every country today has legal tender that is fiat money. While you can buy and sell gold and gold coins, these are rarely used in exchange or for everyday purchases and tend to be more of a collectible or speculative asset.

The term fiat derives from the Latin word fiat, meaning “let it be done”[b] used in the sense of an order, decree[2] or resolution. Other theories of money, such as the credit theory, suggest that since all money is a credit-debt relation, it does not matter if money is backed by anything to maintain value.